The commercial real estate market much like the stock market continues to improve. Tenants are expanding their operation through lease expansions and building purchases. The amount of absorption this year will be substantial.

As a result of all the positive news, the market is now aggressively changing. We are seeing less free rent, higher rates, longer lease terms, and higher construction costs. Below we have looked at some of the effects of the changing real estate market:

Trends of a Changing Market

Less Free Rent

It was common for the last few years to get 1 month free per term of the lease. That has changed to ½ month per year of the term and rounded up; i.e. 5 year lease would be 3 months free. However there are Landlords not offering any. The amount will depend on the product type, amount of improvements, and credit of the Tenant.

Term Being Pushed

Landlords are pushing lease term. 3 and 5 year leases used to be the norm. Now it is 5 and 7 year leases. 10 and 15 year leases are not uncommon. This trend will continue.

Rental Rates Rising

A fairly obvious trend of an improving market, Landlords are pushing the rates when they can. Many are trying to make up for the last few years and looking for 10% increases.

Annual Bumps Increase

Annual increases are being asked up to 3-5% which is a far cry from the 2-3% which were seen from 2008-12. Some Landlords were doing little to no annual increases, not the case any longer.

Tenant Improvements Increase

The cost to build out space is once again on the rise. Any General Contractor will tell you that their margins were squeezed from 2008-12. For a retro fit of an existing office, a minimum of $15 per square foot will be needed and $30 per square foot for a higher quality space (carpet tile, moving/building new offices, higher end finishes).

The real estate market, like any other continues to change. At this point in time it is moving in the direction of the Landlord with less quality space available. There still are subleases available and motivated Landlords as well as buildings available for sale.

With vacancy rates decreasing and an economy that continues to improve, Landlords are feeling bullish on the Twin Cities commercial real estate market. Recently we conducted a survey with six prominent Landlords to get an understanding as to what their perspective is in the next 6-12 months. The questions asked were:

Have you raised you rates?

Do you plan to in the next 12 months?

Any plans to build a new building on a speculative basis?

How much free rent will be offered in 2014?

The results of the survey were along the lines of what was expected with one surprise. Two of the Landlords surveyed were predicting that free rent would go away in 2014. That would be the first time since 2000 that free rent was not standard in new leases.

Notes from Survey:

Every Landlord expects free rent to decrease in 2014

As mentioned above, two Landlords predict free rent will go away completely in some sub markets

One Landlord expects to build spec in 2014

Most will only build if the perfect site presents itself

Four Landlords have raised their quoted rates, only 1 has no plans to, and the last has plans to start increasing them in 2014

All six would only build 24’ clear and higher for industrial, none have plans for office or flex (single level office with low clear)

Most Landlords are raising their rates on office and industrial between 5-10%. The market for high clear industrial space is tight and there are more situations where Tenants are competing for space. Office still has plenty of space available however there are certain areas where it is tight. For example, Downtown Class A for large blocks of space is extremely tight. The Bone Marrow Group is looking for 200,000 SF with little to no options. They are now getting close to a build to suit near Target Field, which should break ground in 2014.

Rental rates have not increased in years and while Tenants never want their cost of doing business to go up, it really has been a long time since Landlords have seen an increase. It is hard to imagine that free rent will go away in 2014 however if the market continues to improve at the same rate, it very well could. The Landlord could have the upper hand in 2014 or 2015.

The one item that the Tenant almost always has in their favor is the high cost to replace them. When a Tenant moves from one location to another, the cost to re-Tenant is almost unavoidable. Down time, tenant improvements, and real estate fees are associated with finding a new Tenant and are expensive. That is not likely to change any time soon.

Now that the Fiscal Cliff has been averted and a new tax deal is in place, there will be several implications to those that lease or own commercial real estate. That pretty much covers all of the business world. Below is a quick overview:

Capital Gains increase from 15% to 20% for income earners over $400,000 for individuals and $450,000 for married folks

The 2 that will have the biggest impact for Landlords and Tenants are Capital Gains and Leasehold Improvements. Those two items for most, will stay the same for the near future but could change at some point particularly the leasehold improvement depreciation schedule as it expires Jan 1, 2014.

An article appeared on the front page of the Mpls. St. Paul Business Journal recently titled: “Industrial Tenants: Say Goodbye to Free Rent”. As a Tenant advocate, I can tell you that in 2012 that has not been the case, and I can illustrate why it won’t become the norm for awhile yet anyway.

The article quoted a 7% vacancy rate for Twin Cities industrial property, but that figure includes all single tenant facilities which increases the universe and thereby artifically lowers the vacancy rate. The true industrial vacancy rate for the Twin Cities is approximately 13.2%, with the southeast submarket reporting 16.5% vacancy (Mncar 2012 Annual Market Report). Historically, a tight market with very little free rent is one with a vacancy rate around 9-10%. With the vacancy rate dropping about 1% per year, we still have a ways to go to get to a tight market.
Now you can breath a sigh of relief! It’s still a Tenant’s market and will remain one through 2013 and beyond most likely.

In some cases, the market has tightened for some types of industrial tenants, that is, large users looking for 175,000 sf or more of bulk warehouse space. In reaction to this, Liberty Property Trust has pulled the trigger on a 227,000 square foot speculative bulk warehouse facility, and Interstate Companies has already built 200,000 square feet in South St. Paul, and has signed a lease for 50,000 square feet recently for 11 years and 12 months of gross free rent! Free rent was sure in play on that one!
So, with free rent still very much a part of transactions in the industrial sector, what about office space? The Twin Cities office vacancy rate is 16.2% (Mncar 2012 annual market report) and that means free rent will also be alive and well in that sector for some time to come.
In either industrial of office it is safe to say that the largest requirements are going to be filled by Build-to-Suits, with examples like Sanmar purchasing land and building over 500,000 sf of industrial space in Shakopee, or United Health Group building a mega-complex in Minnetonka on the heels of completing 2 other build projects in the last 2 years. The cranes are back on the landscape and that is always a sign of prosperity!
Regardless of which party gets elected shortly, we will all need to focus on how we can improve our bottom lines, and for us, we can boost your profitability in a variety of ways in this current Tenant’s market. Clients will continue to turn to us to: address space efficiency and forecast growth, determine if they are over or under market with their rate, map out strategies to negotiate their next lease (new or renewal), and various other solutions, and what they end up with are typical savings of 10-20% over their last rate, along with space that will be improved to carry them for the next 5 years or so.
If you have a lease expiring in the next 12-24 months, it is prime time for an evaluation of either a best lease strategy or possibly to explore a purchase of a facility. In either case, you can count on seeing a strategy and input that will best serve you and your bottom line!

If you would like a copy of my white paper, “Renewal Assistance, Benefits and Payoffs”, please let me know and I will send it over.

In May of this year Zeller Properties and Invesco Real Estate purchased the 5th Street Towers at Sheriff Sale for $110M or $103 per square foot (PSF). The price paid was $1 higher than the next bidder, MetLife the debt holder. This will be the most significant sale in 2012. Here is the story:

Zeller initially identified the properties shorty after they sold in 2007 as it sold for a high price and subsequently lost a large amount of Tenants, dropping occupancy to 72%. From that point up until today the properties have not reached 80% occupancy. The market is at 85% in comparison. Clearly Carter Properties purchased the buildings at the absolute worst time possible as the recession hit just a year later.

With the prolonged recession, significant drop in rental rates, and increase in market vacancy, 5th Street Towers was doomed. The only thing that could have saved the project was an injection of capital however with an extremely high basis price, the investors would then need to hold for 5-10 additional years with no guarantee that the buildings would stabilize.

Late last year the buildings went into foreclosure with the Sheriff Sale set to happen in the Spring of 2012. The issue with purchasing property from a Sheriff Sale is that most of the due diligence items are not available. Those items include:

Property Inspection- HVAC, roof, elevator, structure, any other item that is sure to come up

Those are the two major items and neither were available to any potential Buyers. With that, certain assumptions needed to be made. Zeller did a number of items to understand the properties leases and condition:

Reviewed the old Rent Roll from 2007 when the properties were last available

Connected with Wells Fargo to understand their lease terms

Toured the properties and guessed at capital costs

It turns out the buildings did need substantial capital improvements including new HVAC, restroom upgrades, among the improvements. However since the properties were purchased at such a low price, the improvements did not affect the investment. Once the buildings reach a market vacancy rate they will provide significant upside for the investors.

Some interesting facts:

Buyers put debt on the buildings just 71 days after purchase

Zeller showed up at the Sheriff Sale with an additional $10M, in case someone bid higher than the debt

Currently have 2M SF of new lease activity

Future Value

The properties have 370,000 SF of vacancy (around 35%) according to the commercial MLS. If the buildings were to reach 90% occupancy, essentially lease 260,000 SF of space at a rate of $15 PSF, then the income would be around $14.4M with a carry cost of approximately $800,000. That leaves a net operating income of $13.6M.

The value on the $13.6M is approximately $180M. The cost to lease the vacancies will be in the neighborhood of $40 PSF or around $10M. If all goes according to plan, the investment will look like this: